Market euphoria and soaring demand for European bank debt could be brought back down to earth if the European Union pushes ahead with the early introduction of rules allowing Cyprus-style raids on bank creditors and big depositors
Following demands from Germany, the European Union law to raid the bondholders and savers of failing banks could take effect as soon as January 2015, three years earlier than planned and in time to hit banks exposed by European Central Bank tests next year.
An early start date has won support from the ECB, uneasy over banks’ reliance on its support, and this week Jens Weidmann, the president of Germany’s Bundesbank, became the latest policy maker to join the chorus of support.
Investors have been buying up bank bonds to make up for otherwise feeble investment returns in an era of record low interest rates. The market mood has picked up so much that hedge funds and others are even ready to invest in Greece, the country at the deep end of the euro zone debt crisis.
The so-called ‘bail-in’ of creditors could, however, revive the worst memories of the debt crisis and mark the currency bloc’s biggest upset since a rescue of Cyprus earlier this year broke a taboo by imposing losses on big savers.
“Animal spirits are back,» said Jacob Kirkegaard of Washington think-tank the Peterson Institute For International Economics. «But this market is not going to last. The situation remains very, very fragile.”
The prospect of the new law has done little to curb enthusiasm for bank bonds; Spanish banks have sold 22 billion euros ($29.5 billion) of unsecured bonds since the start of last year. Nor has it prompted large savers to move their cash to safe havens.
“The market may assume that there is not going to be bail-in, that when the going gets tough, the governments and the ECB will cave in,» said Kirkegaard. «They will have a rude awakening.”
The power to impose losses on bank creditors is the most market-sensitive part of banking union. Germany wants its early introduction in return for giving its full backing for the project to police and support banks in the euro zone.
Berlin wants the rules available for next year’s ECB health checks, allowing losses on bondholders or large depositors of banks with skeletons in their closet.
“I hope that serious investors know what they are investing in,» said Gunnar Hokmark, a member of the European Parliament who plays a central role in shaping the new law.
“Everything is to be seen as bail-in-able. Depositors are, in the end, bail-in-able. If anyone would be surprised by that, they have been away from the debate for quite a long time.”
Originally penciled in for 2018, these rules will be finalized and possibly accelerated by European Union countries and the bloc’s parliament in the coming weeks.
There is a lot at stake. Banks across the 17 countries in the euro zone have 860 billion euros of unsecured bonds, with German banks accounting for almost 200 billion euros, according to Thomson Reuters data.
Banks in Spain and Ireland are selling billions of euros of bonds – Irish banks have issued almost 750 million euros of bonds over roughly the past year – despite uncertainty over their true health.
Investor enthusiasm has not been dimmed by memories of the banking problems that forced both countries to ask for international emergency aid.
These investors would be among the first in line for losses, if problems are uncovered. And yet, the cost to banks of selling such debt is dropping to levels not seen since 2010.
“If you look at the pricing of bank risk across the euro area, that market is sniffing glue,» said Willem Buiter, Citi’s chief economist.
The price for banks of a credit default swap – a form of insurance to cover non-payment of debt – is roughly one third the level it was at the peak of the crisis in 2011.
It is not only bondholders at risk. Savers with more than 100,000 euros at a bank that is closed or revamped also stand to lose out, but depositors, too, appear so sanguine that they haven’t troubled to move their money to safe havens such as Germany.
The volume of deposits in countries such as Greece are holding steady, according to ECB data, just months after capital controls were introduced in neighboring Cyprus.
Savers in Slovenia, where the government is required to help banks weakened by years of reckless lending, are equally calm. After modest falls in deposits after Cyprus, the volume is now holding steady.
Yet ratings agency Fitch estimates the cost of rescuing Slovenia’s banks at 4.6 billion euros – probably too much for the country to manage alone, without a bailout or other radical measures.
“Deposits in countries such as Greece or Slovenia are irrationally sticky,» said Citi’s Buiter. «Many euro area governments have empty pockets or are politically unable to help their banks further without bank creditor bail-in.”
The size of banks’ potential liabilities have long overtaken government’s ability to save them.
ECB data shows that euro zone banks have issued more than 3.8 trillion euros of home loans – more than a third of the bloc’s output and one-and-a-half times the German economy.
This helps explain why Germany, the euro zone’s biggest economy and the country most likely to be called on to bear the brunt of bank clean-up costs, wants the tough rules early.
Last week, the ECB came out in favor of an earlier introduction of bail-in, playing down concerns that this would exacerbate banks’ funding difficulties. Moving forward the date, it said, would provide investors with certainty.
“Markets are complacent and believe the European crisis is over,» said Garry Schinasi, a former official with the International Monetary Fund who now advises governments.
“But the banking system is still fragile in Europe. No one really knows how bad it is.”